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Investing in mutual funds? Know the risks involved in debt funds

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Mutual Funds

Debt mutual funds are schemes that invest in fixed income instruments such as government and corporate bonds, or money market instruments such as treasury bills. They offer moderate capital appreciation and a high degree of safety to investors and help them balance their portfolio for lower risks. Also known as fixed income funds, such schemes are generally perceived as relatively less risky than equity-oriented schemes as they tend to offer stable returns. However, the returns may not always be enough to beat rising inflation.

Debt mutual funds suit investors who have a low risk-taking appetite but want to invest in instruments that offer capital appreciation along with capital safety. Such investors can consider substituting their traditional fixed-income investments in bank deposits with debt funds. However, debt schemes do not offer guaranteed returns as is the case with traditional fixed instruments like bank deposits or post office investments. Like equity schemes, debt schemes are also subjected to market risks.

They may appear simple and stable products than equity schemes but they are also fraught with some complex risks. Therefore, it is advisable that before investing in debt mutual fund schemes, you should make yourself aware of the risks involved. This will help you make informed decisions about your investments in debt funds. Take a look at the four key risks attached with debt mutual funds:

Credit Risk

Debt instruments in which the debt schemes invest have different credit ratings. A higher rating lowers the chances of default in payment by the issuer of such instruments. On the other hand, if the rating assigned to debt securities is low, the chances of default are higher. Having said that, it does not necessarily mean that lower ratings will always result in default. Similarly, higher ratings do not guarantee that issuers will not default. The fund managers of debt schemes typically choose a mix of various such instruments to generate higher but risk-adjusted returns. While doing so, these funds always run the risk of credit risk.

Generally, it is seen that there is a high rate of interest by issuers who have low credit ratings. Since they have to raise the fund, they tend to offer a lucrative coupon rate (rate of interest) to investors. At the time of maturity of their issuances, if they default in payment of interest or principal or both, it negatively impacts the net asset value (NAV) of debt schemes. On the other hand, those issuers who enjoy high and stable credit ratings do not offer high rates of interest and debt schemes invest in them for stable returns.

Interest Rate

It’s worth noting that prices of bonds or fixed income securities are inversely proportional to the cost of borrowing or, simply put, interest rates. This essentially means that when interest rates go up, prices of bonds decrease. And the opposite happens when interest rates move upwards. Since debt funds are sensitive to interest rates, those periods when rates are low, debt funds tend to give better returns.

Inflation and macroeconomic stuation

The macroeconomic situation plays a vital role in the performance of any investments, including debt instruments. Fiscal and monetary policies have their impact on the money markets which thereby have their bearings on factors like inflation, bonds and interest rates. A continuous high inflation rate typically makes the central bank and government take measures to control it either by reducing interest rates or by taking actions to improve supply-side dynamics. Such interventions do impact debt investments.

When investment decisions go wrong

Choosing instruments to invest in involves strong research and risk analysis. At times, some of the investment calls taken by the fund managers while building the portfolio of the debt schemes may not yield desired results. It may happen due to too much exposure to certain instruments which did not perform as per fund managers’ expectations and research analysis. Often, when a scheme makes a substantial allocation to certain instruments which unexpectedly default, the overall valuation of the schemes’ portfolio gets negatively impacted.

Investors need to understand that even debt funds, though relatively stable compared with equity, are prone to risks and it will not be right to assume that they are completely risk-free. While the last three risks are generally temporary, the credit risk is permanent. However, it does not mean that you should ignore debt funds completely. Since these funds are professionally managed, fund managers always endeavour to mitigate the risks with timely intervention to ensure there is the least impact on the overall valuations.

Debt funds tend to generate more returns than traditional fixed income products. If planned well keeping in mind the probable risks involved, investments in debt mutual funds as part of your asset allocation can help reach your financial goals.

(Adhil Shetty is CEO, BankBazaar.com.)

(Disclaimer: The opinions expressed in this column are that of the writer. The facts and opinions expressed here do not reflect the views of www.timesnownews.com.)

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